A O Smith Corp (AOS) 2018 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the A. O. Smith Corporation Second Quarter 2018 Earnings Call. (Operator Instructions) As a reminder, today's conference is being recorded. I would now like to turn the call over to Patricia Ackerman, Vice President, Investor Relations, and Treasurer. Ma'am, you may begin.

Thank you, mark. Good morning, ladies and gentlemen, and thank you for joining us on our 2018 second quarter results conference call.

With me participating in the call are Ajita Rajendra, Chairman and Chief Executive Officer; Kevin Wheeler, President and Chief Operating Officer; and John Kita, Chief Financial Officer.

Before we begin with Ajita's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements.

These forward-looking statements are subject to risks that could cause the actual results to be materially different.

Those risks include, among others, matters that we've described in this morning's press release.

(Operator Instructions) I will now turn the call over to Ajita, who will begin our prepared remarks on Slide 3.

Thank you, Pat, and good morning, ladies and gentlemen. Our 13% sales growth in the second quarter was primarily driven by higher sales for water heaters and boilers in North America and higher sales in China, including currency gains.

Here are a few highlights. We achieved record sales of $833 million. Net earnings of $0.66 per share were 25% higher than our earnings per share in 2017.

We continue to review our capital allocation and dedicate a portion of our cash to return to shareholders. We repurchased 1.1 million shares for approximately $70 million through the first half of the year.

As a result of continued strong cash flow, our board approved an incremental 2.5 million shares to repurchase at its meeting earlier this month. We plan to continue buying back our shares at the previously stated $135 million annual pace, using a 10b5-1 plan and in addition, opportunistically buy back shares in the open market. We announced a 29% increase to our dividend in January. The 5-year compound annual growth rate of our dividend is over 25%.

We repatriated nearly $240 million in the first half of 2018 using the proceeds to pay down floating rate debt and improving the flexibility of our balance sheet.

John will now describe our results in more detail, beginning with Slide #4.

Sales for the second quarter of $833 million were 13% higher than the same quarter in 2017. Net earnings in the second quarter of $115 million increased 24% from the second quarter in 2017. Second quarter earnings per share of $0.66 increased 25% compared with the same quarter in 2017.

Sales in our North America segment of $534 million increased nearly 14% compared with the second quarter of 2017, primarily due to higher volumes of water heaters and boilers in North America and pricing actions related to steel cost increases. North America water treatment sales, comprised of Aquasana and Hague, incrementally added approximately $7 million to our North America segment sales.

Rest of World segment sales of $308 million increased 13% compared with the same quarter in 2017. China sales growth was 12%, including a benefit from currency translation of approximately $19 million. China sales grew 4% in local currency. Pricing actions in mid-2017, primarily due to higher steel and installation costs as well as higher sales of gas tankless water heaters and water treatment products, contributed to higher sales and were partially offset by a decline in air purification products and e-commerce sales compared with the prior year.

On Slide 6, North America segment earnings of $125 million were nearly 15% higher than segment earnings in the same quarter in 2017. The favorable impact from higher sales in water heaters, boilers and pricing actions in the U.S. were partially offset by higher steel and other input costs. North America segment margin was slightly higher than last year.

Rest of World earnings of $35 million improved 7% compared with the second quarter of 2017. Higher China sales, including the price increase, were offset by higher engineering and advertising costs. In addition, higher depreciation and utility costs and inefficiencies, all associated with the new water treatment plant, negatively impacted earnings.

Translation gains compared with last year added approximately $2 million to earnings. Second quarter segment margin of 11.3% was lower than 1 year ago due to these factors.

Our corporate expenses were similar to last year. Our effective income tax rate in the second quarter of 2018 was 21.7%. The rate was lower than the 27.8% experienced during the second quarter last year, primarily due to lower federal income taxes related to tax reform. The lower effective income tax rate benefited second quarter 2018 earnings by $0.05 per share.

Cash provided by operations during the second quarter of 2018 was $173 million compared with $73 million provided during the same period in 2017. Higher earnings and a smaller investment in working capital were the primary drivers of higher cash flow compared with last year.

Our liquidity position and balance sheet remain strong. Our debt-to-capital ratio was 12.5% at the end of the second quarter. We have cash balances totaling $658 million located offshore, and our net cash position was approximately $410 million at the end of June.

During the first half of the year, we repurchased approximately 1.1 million shares of common stock for a total of $70 million. Our board approved the repurchase of an additional 2.5 million shares at its meeting in July. The new authority is in addition to the authority to repurchase approximately 1.3 million shares, which remained at the end of June.

This morning, we upgraded our 2018 EPS guidance with a range of between $2.59 and $2.63 per share. The midpoint of our adjusted EPS guidance represents a 20% increase in EPS compared with our adjusted 2017 results. Our EPS guidance excludes $0.03 per share of plant closing cost. Excluding the U.S. tax reform benefits, our operational performance is expected to improve by 12%.

Please turn to Slide 9 for several 2018 assumptions. We expect our cash flow from operations in 2018 to be approximately $475 million, which is significantly higher than the $326 million generated in 2017. We expect higher earnings and lower outlays for working capital this year.

Our 2018 capital spending plans are approximately $100 million. Our depreciation and amortization expense is expected to be approximately $80 million in 2018. Our corporate and other expenses are expected to be approximately $48 million in 2018, slightly higher than the $47 million in 2017, partially due to higher projected spending at our Corporate Technology Center.

Our effective income tax rate is expected to be between 21.5% and 22% in 2018, lower than the previous year due to U.S. tax reform. We expect to repurchase our shares in the amount of approximately $135 million in 2018 under a 10b5-1 plan, similar to 2017. We may supplement our 10b5-1 plan with opportunistic share repurchase in 2018.

We expect our average diluted outstanding shares in 2018 will be approximately 173 million.

Kevin will summarize our guidance, the business assumptions for the remainder of 2018 and our growth strategy, beginning on Slide 10. Kevin?

Thank you, John. Our outlook for 2018 includes several tailwinds and headwinds. First, our tailwinds. We project U.S. residential water heater industry volumes will increase approximately 350,000 to 400,000 units in 2018, due to continued new construction and expansion of replacement demand. This assumption includes tankless units.

Boiler revenues grew 10% in the first half of 2018, driven by solid demand for our commercial boilers and recently introduced products. We expect our boiler sales to grow approximately 10% in 2018.

As a result of significant higher steel prices, inflation, freight and other costs, we announced a price increase effective in early in June, which will average approximately 10% on the majority of our U.S. water heater products. Given significant depreciation of the China currency in the last month, we now project a full year translation benefit of approximately $33 million compared with sales in 2017, which is $22 million smaller than our April forecast. Our projection assumes that China currency will appreciate slightly from current levels during the second half of 2018, resulting in a small translation detriment of approximately $7 million to sales in the second half compared with rates in 2017.

We expect the losses in India to decline from $7.5 million loss in 2017 to a $5 million loss in 2018. The headwinds are higher steel prices and lower China sales growth.

In the second half of 2018, we expect local currency sales in China to grow at a slightly higher rate than the first half or approximately 6%. Sales are expected to be negatively impacted in the second half of the year by high channel inventory levels, which we believe to be the result of recently significant declines in the growth rate housing sales in China.

For the full year, we project more than 8% growth and 5% in local currency terms. We are confident in the underlying fundamentals of our China business, including a well-known premium consumer brand and reputation for innovation, reliable products. And housing sales recover before the end of the year, we project China sales contribution of double-digit sales growth for the next year and beyond to remain intact. New product introductions, fast-growing water treatment products, improvement in housing formation and growing replacement demand are expected to drive future growth.

Lastly, we launch our A.O. Smith-branded water treatment products at Lowe's next month. The combination of our recent acquisitions of Aquasana and Hague, coupled with our globally accepted innovative water treatment technologies and internally developed product selector tools and branded displays, provide a compelling product proposition to customers interested in the quality and safety of their home's water. We expect $15 million of sales and a $1 million to $2 million loss this year due to start-up and transition costs.

Please advance to Slide 11. Primarily as result of strength in North America, we're optimistic about our growth and bottom line performance for 2018. We project revenue growth will be between 9.5% and 10% for the year. We raised our guidance for the full year to $2.59 to $2.63. As a reminder, our third quarter will be burdened by lighter water heater volume driven by seasonality and the water heater price increase related to prebuy, which benefited the second quarter; start-up cost for the new Lowe's water treatment business; and higher steel costs.

Despite subdued third quarter performance, we expect 2018 second half earnings will be stronger than the first half of the year. We expect North America adjusted segment margin for the year to be between 22.25% and 22.5%, with the third quarter negatively impacted by the start-up and transition costs of the new Lowe's water treatment business and lower water heater volumes.

We project weaker performance in the Rest of the World segment in the third quarter, but recovery in the fourth quarter as normal seasonality is expected to favorably impact China and India volumes later this year. For the full year, we expect Rest of World margins to be flat to slightly down from last year.

Please advance to Slide 12. Earlier this year, we updated the components of our growth model to be consistent with the new disclosure rules for disaggregation of segment revenues as well as to incorporate recently acquired and organically fast-growing businesses. We are comfortable with our 8% local currency growth model for 2019 and beyond, predicated on housing recovery in China.

That concludes our prepared remarks, and we're now available for your questions.

Before we go on, I want to just the kind of summarize and put it all together. This is Ajita.

Now 2018 is turning out to be a very solid year for us. It's almost 10% top line growth, 20% EPS growth over last year. And we are achieving this without all of our units performing at top performance, at top levels, and this shows the strength of the portfolio of businesses that we have. And as Kevin said, we are very comfortable with the longer-term 8% organic growth guidance that we've been giving you. Pat, anything else you want to add?

I'll wrap up at the end.

Okay. I guess we're done and open for questions.

(Operator Instructions) Our first question comes from the line of Scott Graham from BMO Capital Markets.

And Ajita, I know that you are not leaving us, but as this is, I'm assuming, your last conference call leading the call, I just want to say congratulations and good luck, again, even though I know that you'll still be around.

Thank you. Yes. I'll still be around for quite a while.

For sure. So, I guess, my question, of course, will be on China. And I guess the way I'm looking at this is that you have a CEO transition taking place. You've got an Analyst Meeting coming up in November. So I'm assuming internally you've kind of flushed out what you're thinking on China, at least in large part, I'm guessing. And so I guess my questions are this. First of all, the slowdown in housing in China has kind of been with us for a while. The completions have been weak for a while. I'm just, I guess, I'm kind of wondering why all of a sudden, is there an inventory channel build as opposed to not having occurred earlier? And then secondly, I guess, my thinking here is that obviously water treatment is now kind of taking the lead there. Would you expect the water heater market to revert back to that 7% growth next year, and why?

So Scott, I'll start, and they can fill in. I mean, it is kind of a first half, second half, there are different items that have come up. We had talked about the first half being up about 4%, and that's about where it came up, and it was due to 2 reasons. The growth wasn't as much as we expected, but it was the 4% that we had talked about, and that was 2 reasons: one, air purifiers down about $18 million from last year's first half; and then the second piece is our online sales are down about 13% when you take out the air purifier portion of that. Now we had talked on the January conference call that there was a prebuy, and we had actually even said that some of it was from online. So the decline in online was impacted by that. And as well as, quite frankly, we didn't come out with a water treatment product for online as quickly as we thought we were going to. So that impacted the first half. Now your question is what's changed with respect to the second half, and I would tell you it's a series of things. One is when we were talking in the first quarter, appliance sales were strong. Consumer spending was strong. But you're right, it had started flattening. Housing has started flattening, which is the first time it hadn't grown for a long period of time. The inventory levels from the year-end to the first quarter grew exactly the same amount in units as the prior year December to first quarter, okay? So when we looked at -- look out at the second half, we were saying we think we can get back to more normal growth. Now let's roll through the second quarter. What happened is inventories actually grew. They grew about 15%. Historically, first quarter to second quarter, they would have been flat or down. Number two, we relooked at what we're seeing in the air purifier. We talked on the first call, $40 million. We are coming out with new products, but we think more realistic is last half down a little bit from last year's last half. So that's a $15 million decline from what we said about first quarter. And then as we talk to our distributors, I mean, there is concern, right? Consumer confidence, the economy slowing down there. Housing hasn't turned. It's been flat now for 2 or 3 quarters. The currency has dropped dramatically in the last month. It's dropped 6%. So it really had us step back and kind of take a look and say, "We need to kind of get through the inventory. We need to get through this half of the year." And that was really the driver on saying our second half sales are going to be up from the first half but not what we expected. So that's a long litany, but I mean, that's how we'd looked at it internally recently. And again, our people have talked to distributors in July, and we just thought it prudent to take it down.

Well, that was very clear, John, as far as what's going on in this year. I very much appreciate that. I guess I'm hoping the part 2 of the question is you guys have expressed, Ajita, your wrap-up comments as well expressed a lot of confidence in your business model in China, and it's understandable. I guess the question would be you're comfortable with the 8% organic long-term, but is it -- is 2019 the year where that business is just so big now in China that maybe the target shouldn't be 15. Maybe it should be 12. Is 2019 the year where maybe we have to pull that down a little bit and then maybe water treatment in the U.S., for example, fills the gap between that and the 8%?

Yes. Let me make some comments on what you said. First of all, the longer-term fundamental, I feel very comfortable with as I said. What's going to happen in 2019, I don't know. Because right now, what's driving this slowdown in China is the economy in China and the slowdown in housing. Now we know that, that's going to improve at some point. And in fact, you would have seen over the last few days the Chinese government has started taking steps to increase liquidity and put more money into the economy, okay? So when that comes back, we expect the economy to come back. The fundamentals in China in terms of this massive movement of people into the middle class, the strength of our very strong consumer brand and our distribution, all those fundamentals are very solid. And I think that as you look at this and you look at -- put this -- overlay this on our results so far this year and the guidance for the full year, which is the almost 10% growth and the 20% EPS -- 10% top line growth and 20% EPS growth, it just shows that the strength of the portfolio that we have, that even without all the businesses at top performance, we're still able to get this kind of performance. So we feel very comfortable going forward. The specific question you had in terms of what's 2019 going to be like, it really depends on how quickly the Chinese economy comes back.

The only other comment I'd give you, Scott, is you know our growth model now talks about 14% growth for those high growing. And you're right. We do expect India to grow above that. We do expect our North America water treatment to do that and keep doing above that. We don't need China to grow at 14%, but we're not giving up by any means because of the issues that, I mean, that the macro factors that are there. But that's why we're comfortable in total with that 14% for 2019 for the high-growth business.

With the understanding that you might have to lean on that diversification that I alluded to and that you're alluding to now that China might actually be going forward, not the 15% organic growth, but maybe something a couple of points less than that?

Yes. And again, I'd say we're certainly not giving up on that, but in '19, that's certainly the possibility, without a doubt.

Yes, it depends on when it comes back. But we've always said every portion of that equation is not going to be hitting every time. But in total, we're very comfortable. And again, I go back to 2018 is a great example that we're hitting our longer-term guidance top and bottom line without every unit performing at peak performance.

Right, and I appreciate that. If I can just sneak in a follow-up here on the Rest of World margin because I know you guys have been frustrated at its level for some time. In fact, 2018's Rest of World margin, call it 13% and change, there was a lot of trials and tribulations within that number. So would that suggest that the setup here for after this year that you can actually start to push that margin up having again with the 2018 issues kind of doing a bit of a reset on purification, maybe even on water heaters. Does that portend well for improvement in margin on Rest of World after this year?

I mean I'll let Kevin answer the going forward, but I think this year margins are certainly being impacted. And we've actually dropped them from our last call because air purification, we had told you, was going to lose $5 million. It's now going to lose, we think, closer to $8 million. So we certainly have an area there that we have to address. Number two, what also is having a factor on margins this year, which we've also talked about is we brought a new water treatment plant on board. And we had inefficiencies. As we talked about in the script, we had higher depreciation in utilities, which we knew, and that was all built into the $5 million. But you're right. Going forward, we certainly expect efficiencies in that plant are going to help offset that. So I'll let Kevin talk going forward.

Well, going forward, certainly we will get efficiencies from our new water treatment plant. The -- some of the, I guess, headwinds behind us will be behind us. We'll improve our e-commerce sales. We'll have new products coming to market, a number of categories: water treatment, tankless and water heaters. So going forward, we do see be able to leverage our operations and also increase those margins. Again, they'll be incrementally, 0.25 points, 0.5 points moving forward, but we do believe, and we continue to put programs in place, where we believe we can move the Rest of World margins forward. Again, John talked about India. There's a number of other areas that are going to help us as we go forward to increase those incrementally over time.

And our next question comes from the line of Matt Summerville from D.A. Davidson.

A couple of questions. Just again sticking with the China business. Can you give more specificity? You mentioned where you felt air purification would come in. Where do you feel the water heater business is going to come in, in '18 versus '17 as well as water treatment?

Well, I'll start with water treatment. So water treatment was up in local currency terms about 15% in the first half. But again, it's a Tale of 2 Cities. The offline was up significantly over 25%. The online was down almost 25%. And again, the online being 2 factors. One, there was an inventory build; and two, we didn't have the product that we wanted to bring to market. So I would tell you in general, we're very pleased with the first half of water treatment. When we look at the full year, we expect the second half growth to be more than the first half. So we're calling for water treatment to be in kind of the 18% to 19% type in local currency terms and even more than that, U.S. dollar terms. So we're pleased. Again, we get that new product out. It's going to eliminate a lot of the connections. So we're optimistic on that product. But again, it's complex, and we had a big move go on. So we're later than we expected. So water treatment's doing very well. Water heater offline had a good first quarter, a good first half. But quite frankly, we're not expecting that in the second half as we work down the inventory. So we'll say the second half is going to be somewhat flattish to up a little bit in RMB terms, but we think it's important to reduce those inventory levels.

And as my follow-up with respect to the price increase you put in place in early June, would you say the majority of that 10% or the full 10% is sticking at this point? And then can you also just maybe put that in the context of -- you mentioned, I think it was maybe Kevin in his prepared remarks, that you felt that the prebuy you saw in Q2 would impact volumes in Q3. But I thought on your first quarter call, you had felt that maybe that wasn't a factor. So I guess I'm trying to understand the change in stance on that issue.

Let me take the -- as far as the price increase that we announced in early June and the up to 12% with a 10% average across-the-board, that's been executed and implemented. With regards to the prebuy, what we said is, it would be a minimal to, we believe, no prebuy just because of the timing of it, early June. If you look at our AHRI data, we had a very strong April, had a very strong May. And I would tell you we had a strong June. When you put them all together, we believe the industry's up about 300,000 units. And that would indicate there was some type of prebuy. The math that we've done, we figured somewhere in the neighborhood of 100,000 to 150,000 units were pulled forward. And I would tell you that's about a week, maybe even a little bit less. So it was minimal, but there was a prebuy. And we felt that it was important for us to explain that to you on the call.

And we don't know for sure. But I think as Kevin said, June being up was a surprise to us. And we talk to our customers, and I'd say inventory levels are a little bit heavy, not bad but a little bit heavy. So I think we just assume, for the most part, that the June excess was a prebuy. That's our impression.

Our next question comes from the line of Jeff Hammond from KeyBanc Capital Markets.

So just on North America, is there a way -- if you look at the 12% growth, is there a way to break out units versus price? And then maybe just speak to what -- I jumped on late, I don't know if you'd mentioned what boiler growth was in the quarter.

Well, I'll start. North America, we don't traditionally break out price and volume. But I will tell you, residential volumes were up significantly in the quarter. Commercial volumes were up in the quarter, not as much. Boiler sales were up 10%. I will tell you Lochinvar as a whole was up even more than that because they were strong in their water heater and their custom commercial water heater. And then you throw in what we talked about, North America water treatment up $7 million or so. It's all of those factors come into why volume was very strong in North America.

Okay. And then just it looks like the margins year-to-date are 23%. North America, you're guiding it to a lower second half. Can you just speak to why the margins stepped down just given that price seems to be running through?

Yes, and it's really the third quarter. I mean, we would expect fourth quarter margins to be fairly consistent with last year. It's really the third quarter, and it's a few factors. One is we talked about the loss we're going to experience on Lowe's as we buy back the inventory, the transition costs. Much of that hits in the third quarter. Seasonally, third quarter residential volumes are lower than normal than the other 3, I'll say. And then we think that gets extended because of a little bit of prebuy. So I think those are probably the 2 biggest factors on why the third quarter margins is we would expect would be down. But again, fourth quarter back to normal.

Okay. And then D&A, it looks like you're running -- you're saying $80 million, and you're running I think $35 million through year-to-date. What's the dynamic there that steps up?

I would have to look. I think we've obviously had some capital, but I would say that number might be a little bit high.

And our next question comes from Charley Brady of SunTrust Robinson Humphrey.

Can you guys quantify the Lowe's impact that's going to hit in Q3, either dollars or margin-wise?

Yes. Right now, we anticipate Lowe's to be on a sales side of about plus $15 million. And then there will be a loss of about $1 million to $2 million just due to the various transition costs, the displays and so forth that we'll need to do to convert the 1,700-plus stores.

In the third quarter, it costs us almost a point compared to -- if you didn't have North America water treatment and just the other businesses, it costs us almost a point.

Okay, got it, got it. Makes sense. And then just in terms of the -- talking about China advertising costs, I guess, and looking at the Rest of World margins, I mean, you talked about getting that up. I mean, can you just -- is there something driving a short-term spike in some of that? Is it a function of you trying to get air purification sales up and doing more advertising in that area? Or what's really pushing some of that?

Well, we have done some of that. We had run some promotions. If you're talking the second quarter, the second quarter is traditionally higher because we have some of the trade shows, et cetera. And so we have Aquatech, et cetera, et cetera. So those costs normally are more in the second quarter. We would expect those to come down as we go into the third and fourth quarter.

Okay, great. And then just one more on the plant efficiency ramp. Is that a 1 quarter kind of ramp? Or you think we're just going through 2018, and we get the full efficiencies starting in '19?

We will get the -- the inefficiencies will be second quarter and then part of third. And we look to make up the balance of our deficit by the end of the year. So it'll be contained within the 2018 time frame.

Our next question comes from Michael Halloran with Baird.

So first, just following up on Lowe's water treatment side. Obviously, you have probably a little bit of revenue onboarding above trend. And then, obviously, the profitability level pressures. Could you help on an annualized basis, once you get past the start-up costs, talk a little bit about what that annual run rate for revenue looks like? And then also how you're thinking about profitability on that business?

Well, I think we talked a little bit about that on the last call. And we had said that next year -- so Lowe's is adding about $15 million this year, and we said it could be adding about $20 million incremental next year. So up to $37 million. This year, North America water treatment, because of the one ramping up and then these transition costs, are going to be in the high single digits. But as we go into next year, I think our focus is, I think we even talked on the call to get those to about 13% for the entire business. And then to be able to continue to grow that as the Lowe's business continues to grow. So as we go down the road, I think we're still focusing on trying to get to that 20%. It's going to take us probably 3 years to get there, '19, '20, '21, but we think those are achievable as volumes pick up and we get through this transition.

That makes sense relative to the previous comments as well. And then the follow-up there from an earlier question, did I hear right that you said 300,000 units on-boarded for the front half of this year for residential water heaters? Is that accurate?

Yes, I would say we're up a little bit over 300,000, probably even puts you close to 325,000 or so.

And then full year expectations are in that, what was it, 400, 350 or 400 kind of implying a slowdown in the back half of the year?

So what you have is you have some move, right. If you say you're up a little over 300,000, and you expect that about 100,000 of it was maybe a prebuy, that would have had the first half be up closer to 200,000, right? So I would tell you the prebuy is probably the biggest factor in that year-over-year.

All right, that's what I was looking for. And then what you're essentially saying then is you normalized for prebuy relatively smooth underlying -- a consistent underlying demand better?

And I'll tell you, and Kevin can talk better than I can, but I talked to the sales people a couple days ago, and the industry is strong, there is no doubt about it as they talk to their customers, et cetera, both commercial and residential.

I would say that it's across-the-board in our distribution contractors, both businesses, Lochinvar and our U.S. water heater business. There's just a solid trend and good growth rates across-the-board.

And we haven't talked about -- enough about Lochinvar, probably. We've talked about them being up 8% for the year. First half of the year, they're up over 10%, and we expect them for the year to be up over 10%. So that's one of the pluses when we look at the full year is we're taking Lochinvar up because not only has their first half been strong. Their orders are strong. The backlog is strong. And as we look at some of the data, [quotes] are up. So we're optimistic on it.

And our next question comes from the line of Ryan Connors of Boenning and Scattergood.

Great. Wanted to first talk about the China situation from a bit of a different angle. There's been a lot of talk in some of the popular financial press about branding impacts for American companies. More -- that talk's been more on the auto side and things like that. But, obviously, your brand is an American brand. It's English characters on the brand and all that. So it's clearly American. And you got all this saber rattling and there's talk about that having a negative impact on American brands in China. So what's your take on that? Obviously, it's a tough issue to handicap it with any kind of granularity, but what's your take on that? And what are you doing, you talked about advertising and so forth, what are you doing to kind of ensure that there is no negative impact on the brand with all this talk?

Let me take a stab at that, and I was in China last week. So this is pretty, pretty up-to-date. There is a lot of chatter in social media and stuff like that. But we haven't seen any impact that we can directly point to it impacting our brand. And we don't really expect it because compared to much more visible brands like Coca-Cola or KFC or Apple, we kind of fly under the radar. So we don't really expect to have much. In terms of advertising, it's the normal game plan. We're not doing anything too different. We're not pulling back. It's the normal game plan.

Yes. We probably stopped, what, I think almost 2 years ago focusing (inaudible) as an American company.

Right, in terms of advertising.

Yeah, because we had so many different SBUs that we're working with that we had pulled back on that from advertising 2 years ago.

Yes.

Our advertising is much more focused on products innovation, bringing benefits to the consumers in the markets, rather than what it has in the past.

Right. We started off way back as being U.S. water heater company. That was the focus of our advertising and our brand. But now our brand has evolved into a water technology, innovation brand. And so our old advertising message has evolved with that.

Got it, okay. And then, I guess, my second one just had to do with Lowe's. And my question is, is there a aftermarket service element to the arrangement with Lowe's? I assume Lowe's plays some role in installation, but then in terms of aftermarket servicing on these systems, is that something that's going to be taken care of for the customer through Lowe's? Or is that something that A. O. Smith is involved directly in? How does that work?

Well, certainly there's an aftermarket with filters. And so Lowe's will carry a full line of our filters as far as from a replacement standpoint. So yes, there is, and there is some installation, which Lowe's will provide on some whole house activity that we have in products. But overall, the products will have a replacement market for many years as the filters -- the various filters we have are used and replaced.

Got it. Okay. But in terms of service, you're not involved directly in any kind of service work, not the resell of filters or the replacement filters, but actual system troubleshooting if there's a problem or something like that?

No, we're not involved in that at all. Let me just add to that we'll have toll-free numbers in call centers and so forth to walk people through. So yes, we'll be involved if they need some questions. Certainly, we'll have some items on the Internet to walk them through the process. But overall, the service on an ongoing basis, no.

And our next question comes from the line of David MacGregor of Longbow Research.

Yes. Just a question on China again. If you think about the situation there, you've got a slowing macro. You've got high channel inventories. In the Western world, this would be ripe for some very aggressive promotional sort of channel clearing. Maybe in China, business practices are a little bit different. But given that you're up against Midea and Haier, which are both pretty aggressive players, it would seem to me that the promotional environment must be picking up here pretty aggressively. And I was just wondering if I can get you to comment maybe, Ajita, you mentioned you just got back. What are you seeing there in terms of inflection in promotional activity? And how is that likely to impact margin play here in the second half?

Well, there's certainly been quite a bit of promotional activity by various competitors. We talked about that during the air purification. Our approach is we certainly have many programs to move our inventory, and we'll do some promotion, some bundling. We'll do it in a systematic way. We'll also do it looking at where inventories are at, what categories do we have higher inventories, and we'll continue to move that forward. But our approach will be not -- it will be again thoughtful, a systematic approach to reducing inventories over time. And we're going to be looking to reduce our inventories somewhere in the neighborhood of about 30 days by the end of the year.

And it's that balance between how do we get the inventories down but still maintaining the type of price points that our brands calls for. So it's that balance, and our team is very good at doing that and has done it in the past, and we're very comfortable with the programs that we have. And we tend to, as Kevin said, bundle with other products and promote in that manner. So in that sense, it is somewhat different in China than the U.S. market.

Do you sense that your channel inventory situation is unique to you and your competitors are not seeing a similar situation? Or do you feel like maybe all the major players are dealing with this inventory surplus?

We don't know. We don't really have any data that can say what the other competitors are like in terms of inventories. But the slowdown has to be hitting everybody.

We don't see the numbers from a share standpoint haven't moved much. So as Ajita said, we don't know, but you have to assume everybody's kind of in the same.

Sure. That would make sense. I guess you've always demonstrated tremendous price discipline, and you talk about your commitment to continuing to do that. I'm just wondering how you manage to maintain that price discipline dealing with this inventory and also maybe competitors that aren't quite as disciplined and historically haven't been. How do you manage those potentially mutually exclusive goals?

It's a tough balance, but it's a day-to-day management of it. And in fact, we've -- there is channel conflict and pricing conflict and things like that in the market. And we try to stay very disciplined and in fact, some of our customers, especially e-commerce customers, have come back to us and complimented us on managing that whole process as best we can given the rules and the laws and what we can do and what's under our control.

Well, you've got a history of doing well there, so good luck with that. Second question if I could is just on your raw material inflation. What's your expected second half steel cost inflation versus the first half?

Up significantly. That's -- it really started, as we said, there's a 3, 3-plus [indiscernible] depending on the situation. So we said that in the last call that first quarter, the second quarter was up, but the last half of the year was up significantly, and that's why we said this price increase matches up with that pretty well.

Is there any chance of getting a little more granularity than "up significantly?"

No, but I mean, I can tell you these facts. I can tell you how much steel is up. Steel is up from the end of the year. It's up 20-some percent. It's up 20% from the first of the year. Hot-rolled is up 41%. When we talked in April, hot-rolled is up even more from that while cold-rolled has steadied, which is good. And again, a lot of that impact is coming in the second half of the year.

But those are spot price dynamics, and I'm guessing...

No. We end up getting priced off of spot, to a degree. But I mean, plus or minus...

Because even though we have contracts...

Yes.

They are based off of pricing indices in the steel indices.

So I guess you can assume that the majority of that increases in the second half.

And presumably, those contracts, there's some leakage of inflation coming through so you're not getting perfectly fixed cost there? As the spot price is increasing, you're getting some leakage of that inflation that's coming through your contracts?

I'm not sure what you mean, but we're not going to get into details of the contract.

And our next question comes from Alvaro Lacayo of Gabelli.

So I just wanted to start with the Rest of the World, 2 questions. One, for that 5% organic China growth number or if you want to just talk about the first half via the 4% organic number, how much of that was volume driven? And then maybe comment just on water heater and water treatment products separately. And then can you quantify inefficiencies from the water treatment plant? And with regards to the delay of the product launch, if the inefficiencies had anything to do with that. And if not, what was the cause of the delay of the product launch?

Well, I'll start with the last. The cause was it's a complex product, and then we were in the process of moving major plants from one to another. So those were the 2 factors that entered into where we thought we would have that product, which is going to help us on the online in the first half, and now it's going to be later third quarter, I think. But when you look at volumes, volumes in the first half of the year, water treatment was up significantly. I don't have the percentage in front of me, 10-plus percent. So there was some price in there. and I think water heater volumes were up a little bit. And the transition continues where electric was down a little bit, but gas was up, and then we have some pricing in effect. So I don't know if that answers all your questions or not.

Yes, it does. And just the inefficiencies, is there a dollar amount with regards to...

So if you break out the efficiencies -- so if I look at that $5 million we talked about hit this year, the efficiencies hit in the second quarter primarily. It's really 3 pieces. I'll tell you the electricity because of the size of the plant is probably about $2 million of that increase. The depreciation is about $1 million for the remainder of the year. So you have -- that's $3 million, and you had efficiencies running first half, first half and the first -- and third quarter and what Kevin's saying, by the end of the year, we start offsetting those efficiencies. So that's how you end up in kind of the $5 million-ish.

I'll tell you, the feedback I received, the transition's gone well. It's producing at the levels we thought or better. So those numbers are well within line with what we told you.

But it was a major move.

Major move.

It's a major move.

Got you, okay. And then in North America water treatment, if you could maybe update us on just the organic sort of industry growth that you're seeing. And then just from a selling point expansion standpoint, what kind of opportunities you have if you can quantify that in any way that will support that 14%-plus growth rates or even higher than that going forward.

Well, so I think we've talked about and it depends if you're talking softening, you're talking about trading, et cetera, I think the numbers we've seen this year is kind of high single-digit kind of increases. I think what we're confident we can do is leverage our distribution channels. So we talked about expanding it, ultimately, to plumbers. We think we're the premier online seller of water treatment now as we get in Lowe's and we're able to leverage that growth. I think as we look at those opportunities and bring new products, I think we're comfortable as we look out for that 14%-plus growth for North America water treatment for the next several years.

Yes, and I would just add the dealer network that we have and continue to expand and grow that into markets that we have some gaps in. So overall, the wholesale business is still very early stages. Plumbers are very early stages. Dealers we're continuing to expand, and Lowe's, we're just in the process of getting in the store. So you put that all together and you look forward, the water treatment business has a good runway heading into 2019 and beyond.

And also when you look at the opportunity, I mean, the awareness of the -- how good our water is in the country, is getting more and more. And the whole water treatment category in North America, I think, has tremendous opportunity to grow very fast.

Great, and congratulations to Ajita and Kevin on the transitions.

Thank you.

Thank you.

And our next question comes from Larry De Maria of William Blair.

Okay. Curious, I believe you guys said you wanted to reduce the inventory by 30 days, I guess, by the end of the year, I think is what you said. Just curious what is the normal level of inventory? Obviously, it's at least a month different than that. So -- and would that be normalized if you get it down 30 days going into next year if we have a similar rate of growth, call it mid singles in local in China, would that be an adequate inventory reduction? Or would that require further inventory reduction next year?

I would tell you that, that is going to be moving in the right direction. If we close to where we want to be, we'll probably like to drive it down just a little bit more over time. But again, moving to 30 days would get us right to a level that we think is appropriate going forward.

Okay, and you're moving it down to 30 days or you're moving it down by 30 days? I'm just trying to understand what's a normal level of inventory.

Sorry, moving it down by 30 days.

Down by 30, and what would that be then? That's like you end up with a quarter's worth of inventory? Or how big is the inventory normally?

That will be a little bit less than a quarter, yes. If it gets down to that level.

A little less than a quarter.

And that's kind of what we run days, in the 70, 80, 85 range.

Given the complexity of the channels, that's about the level that's required to keep it efficient.

Yes.

Okay, can't go down much more than that. And then secondly, are you guys dramatically rethinking the China air purification strategy long-term? And also to be clear, can we get that to break even next year if we have, obviously, continued volume headwinds there?

My answer is no. If we don't -- if we continue to have volume headwinds. Kevin can talk about the new products we're bringing out.

And at this time, we're certainly committed to the air purification market. Granted, there's been some the air and the things we've talked about in the past. But you look at the products that we recently introduced that are going to address formaldehyde, and that's a year-round issue within most Chinese homes. That's still in the very early stages. As we had mentioned in past that we remain committed. Our engineering, product development continues to move forward. And it's early, but we still believe there's a place in air purification for A. O. Smith and the products that we can bring to market through our distribution.

I mean, it's like we talked about in the last call, is some of the stuff that the government's doing, is that sustainable from an air standpoint? And time will tell. It's difficult to shut down plants and do some of the things they're doing and have that impact on business. But -- so we'll see if they continue to do that in the fourth quarter and first quarter of this coming year.

Right. And I think just to expand on that a little, when you look at the air quality in China, it's impacted by 2 things. One is what's outside in the environment, and that's what we kind of focus on, and that's driven by pollution and qualified power plants and all of that stuff, cars and all that. And then also the air quality that's impacted by -- impacted from the inside of the apartment or the home, which comes from furniture and the glues that are used in furniture and things like that, and this is where the formaldehyde comes out. And as we've talked before, if you recall a few years back, we had the lumber liquidator issue, et cetera, which was the formaldehyde concerns in this country. And that was driven by the glues and the adhesives used in cheaper quality furniture, okay? So that's another issue that's very prevalent in China. We have the products that Kevin talked about that we just introduced. It's the only credible product in the market today that addresses that formaldehyde issue. Now certainly, there will be other products that follow. But we feel that with this and the initial, it's very early because we just introduced it, the initial reaction from the marketplace, especially our retailers, has been very positive. So we feel there is going to be a market. We are going to be in the air purification market. The size of the market, we can't tell, which is why we are being conservative in pulling it down because we don't know how sustainable the actions that the Chinese government has taken to clean up the outside area is going to be. But the inside part and the pollution caused by furniture, et cetera, that's going to be there for a while. There's no indication there's anything happening to address that. And we have the products to address that.

To address your earnings question, I think everybody at this table and the Chinese management realizes we can't lose $8 million on a $25 million business, but I will tell you we spent a lot on engineering this year to bring the formaldehyde product -- we'll bring a fresh air product to market late in the year. But we all understand you can't lose $8 million on that size business. So there will be an improvement. We just can't at $25 million sales be breakeven.

Yes. We won't get to break even.

But there will be improvement.

But there will be certainly improvement.

Our next question comes from the line of Andrew Cohen of Northcoast Research.

My question, and I don't know how well you can quantify it, but you're talking about the Chinese housing market slowing or flattening. But one of the underlying things that's supposed to be supporting you is the growth in the upper middle class, and I'm just wondering if that is also mitigated with this slowdown or if they're independent variables?

I think they're independent. I think the growth of the middle class and the move of the middle class or the massive amount of people moving into the middle class is continuing. Those macro drivers in China, the indicators are very strong and continuing. And in addition to that, the move made by the Chinese government to move their economy to be much more consumption based and less dependent on exports, all that is happening. And all those things and all of those drivers are very positive for our business long-term. We have the short-term impact to housing. And we expect that, that's going to come back. It has to come back at some point. We just don't know when.

My other question's actually fairly simple, but this formaldehyde in the furniture issue that you brought up, does that exist in India as well?

I don't know the answer to that question. There is certainly an air purification opportunity in India. We haven't fully investigated it yet. The issues in the Indian market are different. The forms are built differently. So it's not a 1:1 match. But there certainly is an opportunity.

But the price point is not...

The price point...

...is much different in India. So that's why we're not focused on India at this point.

Right. Price points in really all appliances are different in India.

And I'm showing no further questions at this time. I would now like to turn the call back to Patricia Ackerman for closing remarks.

Thank you for your participating in our call this morning. Please take note that we will participate in the D.A. Davidson industrial conference on September 20 in Chicago, and please also save the date for our 2018 Analyst Day to be held in Chicago on November 5. The timing of our Analyst Day is intentionally set 1 day prior to and 1 block from the Baird conference. To register to attend our 2018 Analyst Day, go to the Investor page of A. O. Smith.com. Have a great day.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.